Document: The Application of Internal Revenue Code Section 280E to Marijuana Businesses: Selected Legal Issues | Cannabis Law Report

Most states, as well as the District of Columbia, have enacted laws relaxing in some capacity criminal prohibitions on the use of marijuana, ^{from qualified medical use to recreational use. A marijuana industry source reported $23.9 billion of “U.S. adult use cannabis” sales and $7.6 billion of “U.S. medical cannabis sales” in 2025; the source projected total U.S. cannabis sales will reach $39.1 billion by 2029. While more and more states have allowed marijuana businesses to operate legally under state law, the federal Controlled Substances Act (CSA) continues to classify marijuana as a Schedule I controlled substance. It is a federal crime to “manufacture, distribute, or dispense, or possess with intent to manufacture, distribute, or dispense” Schedule I controlled substances outside the context of federally approved scientific studies. As a result of this classification, Internal Revenue Code (IRC) Section 280E (Section 280E) prohibits marijuana businesses from taking tax deductions and claiming tax credits.}

This report addresses selected legal questions pertaining to the application of Section 280E to marijuana businesses.

Like non-marijuana businesses, marijuana businesses are subject to tax on all of their income. ^{Under federal law, all income is taxable, including income from unlawful activities. In contrast, not all expenses are deductible from a taxpayer’s gross income. The Supreme Court has explained that tax deductions and tax credits are matters of “legislative grace.” Taxpayers conducting lawful activities may deduct “ordinary and necessary” trade or business expenses when computing their taxable income. Taxpayers may claim tax credits to the extent permitted by statute.}

Section 280E denies tax deductions and tax credits attributable to the trade or business of trafficking in CSA Schedule I or II controlled substances where the trafficking is “prohibited by Federal law or the law of any State in which such trade or business is conducted.” ^{As discussed supra, under the CSA, marijuana is a Schedule I controlled substance, and it is a federal crime to manufacture or dispense, or possess with the intent to manufacture or dispense, marijuana outside the context of federally approved scientific studies. Accordingly, Section 280E prohibits marijuana businesses from deducting expenses and claiming tax credits.}

Section 280E prohibits a marijuana business from taking deductions and claiming credits on any amounts paid or incurred in trafficking marijuana. ^{Section 280E does not define “trafficking.” That said, courts have interpreted the term “trafficking,” in the context of Section 280E, to mean “engaging in a commercial activity—that is, to buy and sell regularly.”}

The prohibition on deductions includes deductions for: “ordinary and necessary” business expenses under IRC Section 162(a), state and local taxes under IRC Section 164, losses under IRC Section 165, depreciation under IRC Section 167, and charitable contributions under IRC Section 170. ^{As a result, marijuana businesses, from farmers and processors to distributors and retailers, are prohibited from writing off many of their day-to-day expenses and overhead costs, such as rent, utilities, compensation, advertising, interest, depreciation, costs of administration, and charitable gifts to promote goodwill.}

When a taxpayer operates more than one trade or business, Section 280E only disallows deductions and credits related to the marijuana business. ^{Under the IRC, an activity qualifies as a separate trade or business when the taxpayer is “involved in the activity with continuity and regularity and . . . the taxpayer’s primary purpose for engaging in the activity [is] for income or profit.” For example, the U.S. Tax Court found a taxpayer operating a community center for members with debilitating diseases was engaged in two separate trades or businesses for the purposes of Section 280E—one that provided a variety of caregiving services and another that dispensed medical marijuana. Thus, the court ruled the taxpayer could deduct expenses attributable to its caregiving services, but could not deduct expenses attributable to its marijuana business.}

Still, multiple activities may constitute a single trade or business when they “share a close and inseparable organizational and economic relationship.” ^{In another case, the Tax Court determined that a taxpayer dispensing medical marijuana and providing caregiving services was not operating more than one trade or business when the taxpayer’s only source of revenue was from the sales of medical marijuana. As a result, the court held Section 280E precluded the taxpayer from taking deductions. Similarly, the Tax Court has ruled that Section 280E prohibits a taxpayer from taking deductions when the taxpayer’s business activities that are unrelated to the sale or distribution of marijuana are ancillary to its marijuana business.}

Section 280E does not prevent marijuana businesses from reducing their gross receipts by the cost of goods sold (COGS) when calculating their federal income tax liability. ^{The term COGS refers to “expenditures necessary to acquire, construct or extract a physical product which is to be sold.” By and large, taxpayers compute COGS by taking the inventories at the beginning of the year, adding the year’s purchases and production costs, and subtracting year-end inventories. A marijuana business may make a downward adjustment for COGS because it is not considered a deduction from gross income—it is outside the scope of Section 280E. COGS offsets gross receipts when determining gross income, whereas deductions reduce gross income to calculate taxable income.}

Since marijuana businesses are limited to reducing their gross receipts by COGS, how they calculate COGS is critical to determining their tax liability. ^{Taxpayers must be able to substantiate any amounts claimed as COGS. For example, a marijuana business can reduce its gross receipts by the cost of the marijuana purchased if properly substantiated.}

Section 280E’s legislative history suggests that taxing gross receipts without providing an adjustment for COGS to arrive at taxable income might be subject to constitutional challenge. ^{This is based on the principle that the power to levy an “income” tax granted by the Sixteenth Amendment to the U.S Constitution refers to “gross income,” not gross receipts, and a tax on gross receipts might be interpreted as “something other” than an income tax.}

Congress enacted Section 280E to obviate the need for courts to apply the common law “frustration of public policy” doctrine in certain tax disputes related to drug trafficking and to codify a “sharply defined public policy against drug dealing.” ^{Prior to the enactment of Section 280E, courts applied the frustration of public policy doctrine to deny taxpayers deductions attributable to unlawful drug trafficking activities. Under the frustration of public policy doctrine, courts weigh the government’s interest in accurately measuring taxable income against the government’s interest in disallowing deductions that “frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.”}

Courts have a long history of applying the frustration of public policy doctrine to deny taxpayers deductions for expenses attributable to unlawful activities. ^{In 1969, Congress precluded courts from applying the frustration of public policy doctrine in certain tax disputes by enacting legislation to disallow deductions of business expenses attributable to specific types of unlawful conduct. Prior to Section 280E’s enactment, Congress had amended the IRC to make fines and penalties, illegal bribes, and kickbacks, and certain other illegal payments nondeductible expenses.}

Congress enacted Section 280E in 1982, ^{one year after the Tax Court decided Edmondson v. Commissioner. In Edmondson, the court ruled that a taxpayer operating an illegal drug business could offset sales by COGS and “ordinary and necessary” business expenses, making no mention of the judicial frustration of public policy doctrine. The court found that the taxpayer was self-employed in the trade or business of selling amphetamines, cocaine, and marijuana. The court held that the taxpayer could deduct business expenses, including rent, telephone, and automobile expenses, because the expenses were “ordinary and necessary” expenses made in connection with the taxpayer’s illegal drug business.}

The Senate Finance Committee’s report accompanying the bill enacting Section 280E indicates Congress enacted the provision in direct response to Edmondson and designed the provision to disallow “[a]ll deductions and credits for amounts paid or incurred in the illegal trafficking in drugs.” ^{The Senate Finance Committee’s report explained:}

There is a sharply defined public policy against drug dealing. To allow drug dealers the benefit of business expense deductions at the same time that the U.S. and its citizens are losing billions of dollars per year to such persons is not compelled by the fact that such deductions are allowed to other, legal, enterprises. Such deductions must be disallowed on public policy grounds.

Section 280E applies when trafficking marijuana violates federal or state law. ^{Section 280E applies to marijuana businesses operating in compliance with state law because trafficking marijuana continues to violate federal law. Section 280E also applies to marijuana businesses engaged in state-sanctioned medical marijuana sales because marijuana is a Schedule I controlled substance under the CSA, and thus cannot legally be used for medical purposes.}

The federal government has not consistently enforced the CSA against state-sanctioned marijuana businesses. ^{However, any lack of enforcement of the CSA does not render Section 280E inoperable. Unlike other sections of the IRC, Section 280E does not contain an exception that makes its application contingent on the federal government’s policy on enforcing the CSA. The IRS is authorized to initiate an investigation into whether a taxpayer is violating the CSA for purposes of applying Section 280E—neither a criminal investigation nor a criminal conviction is a prerequisite to an IRS investigation.}

In Northern California Small Business Assistants, Inc. v. Commissioner, the Tax Court provided an in-depth explanation of its reasoning in ruling that Section 280E does not violate the Eighth Amendment’s Excessive Fines Clause. ^{The Eighth Amendment to the Constitution provides: “Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.” When applying the Eighth Amendment, the Supreme Court’s concerns include “direct actions initiated by [the] government to inflict punishment.” The Court has reviewed the history of the Eighth Amendment and determined that the drafters of the Eighth Amendment understood the term “‘fine’ . . . to mean a payment to a sovereign as punishment for some offense.” The Court has ruled that a fine is excessive where it is “grossly disproportional to the gravity of [the] offense[].” Whether Section 280E’s disallowance of deductions is a denial of a tax benefit or a punishment for the purposes of the Eighth Amendment is a matter of debate. In Northern California Small Business Assistants, a panel of Tax Court judges issued differing opinions on the Eighth Amendment’s application to Section 280E.}

The corporate taxpayer in Northern California Small Business Assistants operated a medical marijuana dispensary, which was legal under California state law. ^{Applying Section 280E, the IRS issued the taxpayer a notice of deficiency explaining that Section 280E disallowed the taxpayer’s deductions. The taxpayer filed a claim disputing the notice, and moved for partial summary judgment challenging the application of Section 280E. At the heart of the taxpayer’s arguments was that Section 280E imposed a penalty in violation of the Eighth Amendment’s Excessive Fines Clause. The panel agreed to deny the taxpayer’s motion for summary judgment, but the judges varied in their approach to reaching that decision.}

The majority opinion, joined by ten Tax Court judges, held that Section 280E does not violate the Eighth Amendment because the disallowance of deductions does not constitute a “penalty” for the purposes of the Eighth Amendment. ^{The opinion emphasized Congress’s unquestionable authority to tax gross income and concluded that Congress was the proper body to address the taxpayer’s grievances. Two Tax Court judges did not advance a view on whether Section 280E imposed a fine for the purposes of the Eighth Amendment, but concurred in the denial of the taxpayer’s motion for summary judgment because the taxpayer failed to show the fine was excessive. Three Tax Court judges concluded that Section 280E does impose a fine, but did not reach a conclusion on whether the fine was excessive.}

A number of legislative proposals would make Section 280E inapplicable to marijuana businesses by rescheduling marijuana as a Schedule III controlled substance or entirely descheduling marijuana under the CSA. ^{A couple of legislative proposals would carve out an exception in Section 280E for marijuana businesses operating in compliance with state and tribal laws. In May 2024, the U.S. Department of Justice issued a notice of proposed rulemaking to transfer marijuana from Schedule I to Schedule III with the aim of rescheduling marijuana to Schedule III using the administrative rescheduling process. Under each approach, Section 280E would no longer prohibit marijuana businesses from taking deductions and claiming credits.}

Some legislative proposals would implement marijuana taxes and regulate marijuana. ^{For example, the Marijuana Opportunity Reinvestment and Expungement (MORE) Act would impose an excise tax on cannabis products produced in or imported into the United States and an “occupational tax” on producers and export warehouse proprietors. The MORE Act would use the amounts raised from those taxes to fund a trust fund for specified programs.}

A couple of legislative proposals would maintain the prohibition on marijuana businesses taking deductions and claiming credits even if marijuana is rescheduled or descheduled. ^{These proposals would amend Section 280E to expressly prohibit businesses trafficking marijuana from taking deductions and credits.}

A few legislative proposals from past Congresses have been designed to increase marijuana businesses’ access to banking and financial services. ^{Many financial institutions are unwilling to provide state-sanctioned marijuana businesses with common banking products and financial services due to potential legal exposure, such as under federal anti-money laundering laws that criminalize the handling of money tied to marijuana. As a result, many marijuana businesses reportedly operate exclusively in cash. A former Treasury Secretary expressed that marijuana businesses’ lack of access to financial services “creates a very large concern.” The former Treasury Secretary also stated: “We have to build cash rooms to take in large amounts of cash . . . where people owe us taxes, because we want to collect the taxes. . . . [T]hose entities are not banked. . . . I would say that creates risk to our IRS employees and to the people in the community.”}